The Liquidity Theory of Asset Prices

Professional investors are bombarded on a day to day basis with assertions about the role liquidity is playing and will play in determining prices in the financial markets. Few, if any, of the providers or recipients of such advice can truly claim to understand the well–springs of such liquidity and the transmission mechanisms through which it impacts asset prices.

This groundbreaking new book explores the belief that at the core of liquidity there is a force which exerts individuals to effect a financial transaction when they would not otherwise do so. Understanding this force of compulsion is a key to understanding a financial market when it appears to be behaving irrationally. This book will enable new and seasoned investors to develop an understanding of the factors, so that costly mistakes can be avoided without the lesson of experience.

Foreword by Russell Napier xiii

Acknowledgements xvii

About the Authors xix

List of Tables, Figures and Charts xxiii

Introduction 1

Appetiser 1

Structure of the book 2

Language and jargon 2

Academic theories 3

Modern Portfolio Theory 3

The Efficient Markets Hypothesis 4

Forms of investment analysis 4

Fundamental analysis 4

Monetary analysis 5

Technical analysis 5

The intuitive approach 6

What the book is going to say 6

PART I THE LIQUIDITY THEORY 9

1 Types of Trades in Securities 11

2 Persistent Liquidity Trades 15

3 Extrapolative Expectations 21

4 Discounting Liquidity Transactions 25

5 Cyclical Changes Associated with Business Cycles 37

6 Shifts in the Savings Demand for Money 43

PART II FINANCIAL BUBBLES AND DEBT DEFLATION 49

7 Financial Bubbles 51

8 Debt Deflation 55

PART III ELABORATION 59

9 Creation of Printing-press Money 61

10 Control of Fountain-pen Money and the Counterparts of Broad Money 65

11 Modern Portfolio Theory and the Nature of Risk 71

12 Technical Analysis and Crowds 81

13 The Intuitive Approach to Asset Prices 87

14 Forms of Analysis 93

PART IV EVIDENCE AND PRACTICAL EXAMPLES 101

15 The UK Markets Prior to 1972 103

16 The US Equity Market 1960–2002 109

17 Two Forecasts 113

18 Debt Deflation, Practical Experience 119

PART V MONITORING DATA 121

19 Monitoring Current Data for the Monetary Aggregates 123

20 Monitoring Data for the Supply of Money 139

21 The Different Sectors of the Economy 145

Glossary 149

References 157

Index 159

About the authors

GORDON PEPPER has the unusual combination of an economics degree from Cambridge and actuarial training. Immediately after he finished taking examinations, he became a dealer on the Floor of the London Stock Exchange. His ‘postgraduate university’ was the market place, where he underwent the harshest of disciplines. Forecasts based on conventional theories were often wrong. The inescapable conclusion was that these theories were either incorrect or incomplete.

Pepper was the joint founder of W. Greenwell & Co’s gilt-edged business (that is, the UK government bond business), which arguably became one of the leading bond-advisory businesses in the world, the advice being about both the best investments and the optimum way to execute business. For more than ten years he was the premier analyst in the gilt-edged market and was often described as the guru of that market. He was the principal author of Greenwell’s Monetary Bulletin, which, in the 1970s, became one of the most widely read monetary publications produced in the United Kingdom

Pepper is the author of three books and the co-author of a fourth: Money, Credit and Inflation (1990), Money, Credit and Asset Prices (1994), Inside Thatcher’s Monetarist Revolution (1998), and (with Michael Oliver) Monetarism under Thatcher – Lessons for the Future (2001). He is also chairman of Lombard Street Research Ltd, which is one of the UK’s leading independent firms carrying out investment research and specialising in analysis of money, credit and flows of funds. Summarising, Pepper’s particular strength is the combination of practitioner and academic. Above all, he writes with great authority from his knowledge of what actually happens in the marketplace.

MICHAEL J. OLIVER is currently Professor of Economics at École Supérieure de Commerce de Rennes and a director of Lombard Street Associates, UK.

He graduated in economic history at the University of Leicester and was awarded his PhD in economics and economic history from Manchester Metropolitan University. He has held posts at the universities of the West of England, Leeds, Sunderland and has been a Visiting Professor at Gettysburg College, Pennsylvania and Colby College, Maine.

He is the author of several books, including Whatever Happened To Monetarism? Economic Policy-making and Social Learning in the United Kingdom Since 1979 (1997); Exchange Rate Regimes in the Twentieth Century (with Derek Aldcroft, 1998) and Monetarism under Thatcher – Lessons for the Future (with Gordon Pepper, 2001). He has just finished co-editing a book (with Derek Aldcroft) entitled Economic Disaster of the Twentieth Century, which is being published by Edward Elgar in 2006. He has contributed articles to Economic History Review, Twentieth Century British History, Economic Affairs, Contemporary British History, Economic Review and Essays in Economic and Business History.

“Central bankers worry about asset markets. Do they convey information about the future course of the economy? How does monetary policy affect these markets – if it does? Should monetary policy attempt to prevent or prick bubbles? These are important matters, sometimes neglected by academic economists. This book, written jointly by a practitioner with a good knowledge of economics and an economic historian with a good knowledge of markets, is most useful and important contribution to the study of the interaction of monetary policy and asset markets. It is a most welcome book.”
—Geoffrey E. Wood, Professor of Economics, Cass Business School,

“Even a beginner could understand this and this is excellent from a treasurer or a CFO’s viewpoint since many of them would gain a better understanding of why their company’s share price is flagging or performing in the way that it is. As an educational tool it is very impressive. I can see the great potential for this in the marketplace. I wish that I had been armed with this when I first went into the City!”
—Michael Shelton – Agar, Director, Lombard Street Associates

“Gordon Pepper makes a clear, well argued case for the Liquidity Theory of Asset Prices. He provides an interesting and revealing perspective on periods of seemingly irrational behaviour in markets. The most important piece of advice I took away with me was ‘don’t listen to what central bankers say, watch what they do’. I would recommend any experienced fund manager to read this and have their preconceived ideas, about market fundamentals, challenged.”
—Anja Balfour, Fund Manager, Framlington

“I think this book will prove extremely helpful to young professionals setting out on a career in asset management and seeking to educate themselves about the investment world. The book is clearly the outcome of a lifetime of hard intellectual work combined with practical experience of markets. I think it will be most useful to aspiring investment managers and I only wish it had been available for me 30 years ago.”
—Richard Burns, Senior Partner, Baillie Gifford